UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended SEPTEMBER 30, 1997
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________________to ______________.
Commission File No. 0-20966
-----------------
CATALYTICA, INC.
(Exact name of Registrant as specified in its charter)
Delaware 94-2262240
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
430 FERGUSON DRIVE
MOUNTAIN VIEW, CALIFORNIA 94043
(Address of principal executive offices)
(415) 960-3000
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
The number of outstanding shares of the Registrant's Common Stock, $.001 par
value, was 52,791,268 as of November 7, 1997.
CATALYTICA, INC.
FORM 10-Q
TABLE OF CONTENTS
September 30, 1997
Page No.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
Condensed Consolidated Balance Sheets as of September 30, 1997 and December 31, 1996 3
Condensed Consolidated Statements of Operations for the three and nine months ended September 30,
1997 and September 30, 1996 4
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 1997
and September 30, 1996 5
Notes to Condensed Consolidated Financial Statements 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS 9
PART II. OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS 22
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 22
SIGNATURES 23
2
PART I--FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CATALYTICA, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
September 30, December 31,
1997 1996
-------------- -------------
ASSETS
Current assets:
Cash and cash equivalents $ 44,328 $ 15,540
Short-term investments -- 8,281
Accounts receivable, net 20,982 3,944
Accounts receivable from joint venture 320 865
Notes receivable from employees 255 328
Inventory:
Raw materials 56,070 1,689
Work in process 48,632 249
Finished goods 5,188 1,479
-------- --------
109,890 3,417
Prepaid expenses 2,728 681
-------- --------
Total current assets 178,503 33,056
Property, plant and equipment:
Land 5,545 --
Equipment 78,781 9,260
Buildings and leasehold improvements 83,155 8,173
-------- --------
167,481 17,433
Less accumulated depreciation and amortization (12,059) (9,536)
-------- --------
155,422 7,897
Other assets 2,193 --
Notes receivable from employees 50 50
-------- --------
$336,168 $ 41,003
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 16,706 $ 2,055
Accrued payroll and related expenses 4,837 1,372
Deferred revenue 1,457 1,643
Accrued acquisition costs 285 --
Other accrued liabilities 7,308 949
Borrowings under line of credit 14,600 2,300
Current portion of long-term debt 25,439 833
-------- --------
Total current liabilities 70,632 9,152
Long-term debt 100,312 1,524
Non-current deferred revenue 3,906 5,064
Other accrued liabilities 6,400 --
Minority interest 11,000 8,000
Class A and B common stock 117,679 --
Stockholders' equity:
Common stock 22 19
Additional paid-in capital 78,269 65,482
Deferred compensation (445) (41)
Accumulated deficit (51,607) (48,197)
-------- --------
Total stockholders' equity 26,239 17,263
-------- --------
$336,168 $ 41,003
======== ========
See accompanying notes
3
CATALYTICA, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- --------------------------
1997 1996 1997 1996
------------ ------------ ------------ ------------
Revenues:
Product sales $66,699 $ 1,922 $76,020 $ 6,624
Research revenues 1,606 1,693 4,832 4,440
------- ------- ------- -------
68,305 3,615 80,852 11,064
Costs and expenses:
Cost of sales 60,223 1,686 69,310 6,129
Research and development 2,470 2,184 6,909 7,726
Selling, general and administrative 2,139 1,000 4,130 3,461
------- ------- ------- -------
Total costs and expenses 64,832 4,870 80,349 17,316
Operating income 3,473 (1,255) 503 (6,252)
Interest income 303 345 808 884
Interest expense (1,881) (62) (2,119) (289)
Gain on sale of assets -- -- -- 505
Loss on joint venture (1,150) -- (2,600) --
------- ------- ------- -------
Income (loss) before income taxes 745 (972) (3,408) (5,152)
Provision for income taxes (2) -- (2) --
------- ------- ------- -------
Net income (loss) $ 743 $ (972) $(3,410) $(5,152)
======= ======= ======= =======
Net income (loss) per share $ 0.02 $ (0.05) $ (0.13) $ (0.27)
======= ======= ======= =======
Shares used in computing net income (loss) per share 42,773 19,326 26,897 19,257
======= ======= ======= =======
See accompanying notes.
4
CATALYTICA, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
(IN THOUSANDS)
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------------
1997 1996
-------------- -------------
Cash flows from operating activities:
Net loss $ (3,410) $ (5,152)
Adjustments to reconcile net loss to net cash provided by operating activity:
Depreciation and amortization 2,552 664
Losses in affiliated company 2,600 --
Changes in:
Accounts receivable (17,038) 1,508
Accounts receivable from joint venture 545 (654)
Inventory 11,027 (2,108)
Prepaid expenses and other current assets (721) 1
Accounts payable 14,651 99
Accrued payroll and related expenses 3,465 26
Deferred revenue (1,344) 6,824
Accrued acquisition costs 285 --
Other accrued liabilities 6,359 328
--------- --------
Net cash provided by operating activities 18,971 1,536
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments (13,184) (19,600)
Maturities of investments 21,532 29,000
Investment in affiliate company (2,600) --
Acquisition of property and equipment (3,651) (2,345)
Acquisition of Glaxo inventory (117,500) --
Acquisition of Glaxo property, plant and equipment (130,497) --
--------- --------
Net cash (used in) provided by investing activities (245,900) 7,055
CASH FLOWS FROM FINANCING ACTIVITIES:
Net receipts on (issuance of) notes receivable from employees 73 (210)
Additions to debt obligations 137,726 1,413
Payments on debt obligations (5,551) (4,932)
Minority investment -- 8,000
Issuance of Class A and B common stock, net 117,679 --
Issuance of Common Stock 5,790 236
--------- --------
Net cash provided by financing activities 255,717 4,507
--------- --------
Net increase in cash and cash equivalents 28,788 13,098
Cash and cash equivalents at beginning of period 15,540 5,021
--------- --------
Cash and cash equivalents at end of period $ 44,328 $ 18,119
========= ========
Non cash financing activities:
Issuance of warrants in conjunction with the Glaxo Wellcome facility acquisition $ 6,500 --
========= ========
Issuance of Catalytica Pharmaceutical's Junior Preferred Stock in conjunction with the
Glaxo Wellcome facility acquisition $ 3,000 --
========= ========
Assumption of liability in conjunction with Glaxo Wellcome facility acquisition $ 6,400 --
========= ========
See accompanying notes.
5
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the nine-month period ended September 30,
1997, are not necessarily indicative of the results that may be expected for the
year ended December 31, 1997. For further information, refer to the consolidated
financial statements and footnotes thereto included in the Catalytica, Inc.
Annual Report on Form 10-K/A for the year ended December 31, 1996.
2. NET INCOME (LOSS) PER SHARE
Net income (loss) per share is computed using the weighted average number of
common shares outstanding during each year, including common stock equivalents
(unless antidilutive). Common stock equivalents consist of outstanding stock
options and warrants issued to Glaxo Wellcome (See Note 7) and common stock
holders (See Note 8).
3. IMPACT OF STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 128
In February 1997, the Financial Accounting Standards Board issued Statement
No. 128, Earnings per Share, which is required to be adopted on December 31,
1997. At that time, the Company will be required to change the method currently
used to compute earnings per share and to restate all prior periods. Under the
new requirements for calculating primary earnings per share, the dilutive effect
of stock options will be excluded. The new requirements are not expected to
affect either primary or fully diluted earnings per share for the quarter ended
September 30, 1997.
4. FINANCIAL INSTRUMENTS
For the purposes of the consolidated cash flows, all investments with
maturities of three months or less at the date of purchase held as available-
for-sale are considered to be cash and cash equivalents; instruments with
maturities of three months or less at the date of purchase which are held-to-
maturity and investments with maturities greater than three months which are
available-for-sale are considered to be short-term investments; investments with
maturities greater than one year are considered to be long-term investments and
are available-for-sale. The classification of investments is made at the time of
purchase with classification for held-to-maturity made when the Company has the
positive intent and ability to hold the investments to maturity. There were no
investments outstanding at September 30, 1997.
5. USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
6
NOTES TO UNAUDITED CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS--(Continued)
6. FORMATION OF GENXON/(TM)/ JOINT VENTURE WITH WOODWARD GOVERNOR COMPANY
On October 15, 1996 Catalytica's subsidiary Catalytica Combustion Systems Inc.
("CCSI") and Woodward Governor Company formed a Delaware limited liability
company in connection with a 50/50 joint venture to serve the gas turbine
retrofit market for installed, out-of-warranty engines. The new company,
GENXON/(TM)/ Power Systems, LLC, will initially upgrade the combustion systems
of installed turbines with XONON which will reduce emissions and permit greater
asset utilization for both power generation and mechanical drive markets.
The initial capital commitment of the GENXON joint venture partners was $10
million--$2 million from CCSI and $8 million from Woodward--payable over time as
the funds were required by the joint venture. This initial capital commitment of
$10 million was reached during the quarter ended September 30, 1997. Continued
funding of the joint venture beyond the initial $10 million commitment has
occurred on a 50/50 basis with each joint venture partner contributing $600,000
during the third quarter, bringing the total investment in the joint venture to
$11.2 million to date. Although CCSI and Woodward intend to continue the funding
of this joint venture, neither joint venture partner is contractually required
to make further capital infusions exclusive of some required capital infusions
which are predicated upon reaching certain milestones.
CCSI recognized its 50% share of GENXON losses for the three and nine month
periods ending September 30, 1997 up to its capital contribution of $1.15
million and $2.6 million, respectively. Accordingly, losses on the joint venture
were recognized in the results of operations.
As of September 30, 1997, an account receivable for $320,000 exists from the
joint venture for costs incurred by CCSI. Accordingly these costs have not been
included in the consolidated entity.
7. ACQUISITION OF GLAXO WELLCOME FACILITY
On July 31, 1997, Catalytica Pharmaceuticals, Inc. (formerly Catalytica Fine
Chemicals, Inc.), a subsidiary of the Company, acquired from Glaxo Wellcome Inc.
a pharmaceutical manufacturing facility (the "Facility") located in Greenville,
North Carolina (the "Acquisition"), in exchange for (i) $245.1 million in cash;
(ii) 250,000 shares of Junior Preferred Stock of Catalytica Pharmaceuticals;
(iii) warrants to purchase 2,000,000 shares of the Company's Common Stock at an
exercise price of $12.00 per share and (iv) 10% of the earnings before interest
and taxes in excess of an aggregate cumulative amount of $10 million
attributable to the sterile products portion of the Facility, up to an
aggregate cumulative payment to Glaxo Wellcome of an additional $25.0 million.
At the closing of the Acquisition Catalytica recorded $117.5 million of
inventory and $146.7 million of property, plant and equipment. During the nine
months ended September 30, 1997, 82.8% of the Company's pharmaceutical product
revenues were derived from sales to Glaxo Wellcome.
With the closing of the Acquisition, the Company closed a sale of 13,270,000
shares of its Class A Common Stock and 16,730,000 shares of its Class B Common
Stock to Morgan Stanley Capital Partners III, L.P. and two affiliated funds
("MSCP") (collectively, the "Stock Sale"), at a price of $4.00 per share, for an
aggregate of $120,000,000. As a result of the Stock Sale, as of September 30,
1997, MSCP owns approximately 40% of the Company's outstanding voting securities
and approximately 60% of the Company's outstanding securities on a fully
converted basis. See "Note 8 Warrant dividend" for a discussion of the
redemption of 5,000,000 shares of Class B common.
Holders of the Class A and Class B Common Stock, at any time after July 1,
2005, have the option to require the Company to repurchase outstanding shares of
Class A and Class B Common Stock for cash based on the original consideration
paid for such shares on the Closing Date of the Acquisition. In accordance with
SEC regulations, the Class A and Class B Common Stock is not shown as part of
equity.
7
NOTES TO UNAUDITED CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS--(Continued)
In addition to the equity investment by MSCP, the Company, The Chase Manhattan
Bank ("Chase") and Chase Securities Inc. ("CSI") have entered into a Credit
Agreement pursuant to which a syndicate of banks led by Chase has agreed to lend
Catalytica Pharmaceuticals an aggregate of up to $200,000,000 (the "Debt
Facilities"). The Debt Facilities consist of a senior secured term loan facility
(the "Term Debt Facility") in an aggregate principal amount of $125,000,000 and
a senior secured revolving facility (the "Revolving Debt Facility") in an
aggregate principal amount of $75,000,000. Up to $20,000,000 of the Revolving
Debt Facility will be available for the issuance of letters of credit. The Term
Debt Facility will mature four and one-half years after consummation of the
Acquisition and will amortize in quarterly installments commencing on the last
day of the third fiscal quarter of 1998 in aggregate annual amounts of (i)
$50,000,000 in the year 1998, (ii) $37,500,000 in the year 1999, (iii)
$20,000,000 in the year 2000, and (iv) $17,500,000 in the year 2001. The
Revolving Debt Facility will mature four and one-half years after consummation
of the Acquisition. As of September 30, 1997, $14,600,000 was outstanding under
the revolving debt facility and $125,000,000 was outstanding under the senior
secured term facility.
8. WARRANT DIVIDEND
The Company distributed, at no cost, to each holder of Common Stock of record
as of August 22, 1997 (the "Record Date"), one Warrant for each three shares of
Common Stock held on the Record Date. The total number of warrants issued was
6,947,245. No Warrants to purchase fractional shares were issued, and,
accordingly, the number of Warrants issued to each stockholder were rounded down
to the nearest whole Warrant. Each Warrant entitled the holder to purchase one
share of Common Stock at the exercise price of $4.00 (the "Warrant Price"). The
Warrants expired at 5:00 p.m. (Pacific time) on October 31, 1997 (the "Warrant
Expiration Date"). Warrant holders elected to (i) purchase Common Stock through
the exercise of their Warrants, (ii) trade their Warrants or (iii) allow their
Warrants to expire unexercised.
The Company used the net proceeds from the exercise of the Warrants to
repurchase an aggregate of 5,000,000 shares of its Class B Common Stock issued
to MSCP on July 31, 1997. The repurchase price was $4.75 per share, as such
repurchase was consummated prior to November 30, 1997. The Class A Common Stock
and Class B Common Stock could not be repurchased after May 31, 1998. Remaining
proceeds of the Warrant issuance will be used for general corporate purposes.
9. REVENUE RECOGNITION
The Company recognizes revenue under the Supply Agreement with Glaxo Wellcome
based upon the guaranteed revenues under this agreement. All other product
revenues are recorded upon shipment. During the nine months ended September 30,
1997, the Company recorded $63 million of product revenue under this agreement
which included $3.8 million of revenue in excess of the actual product shipments
to Glaxo.
10. SUBSEQUENT EVENT
As of October 31, 1997, 6,922,996 shares have been acquired through the
exercise of the Warrants, which generated gross proceeds of $27,691,984. The
Company has used $23,750,000, to repurchase 5,000,000 shares of the MSCP Class B
Common Stock. The repurchase will be reflected in the Company's financial
statements in the period ending December 31, 1997. The Company's earnings
per share will be reduced by $.07 due to this repurchase. Earnings per share
for this purpose was calculated assuming an average of 52 million Shares
outstanding during the fourth quarter.
8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
OVERVIEW
This report contains forward-looking statements within the meaning of Section
27A of the Securities Act and Section 21E of the Exchange Act, including those
statements which have been identified by an asterisk ("*") and other statements
regarding the Company's strategy, financial performance and revenue sources.
Actual results could differ materially from those projected in the forward-
looking statements as a result of certain factors set forth under "Risk Factors"
and elsewhere in this Report.
Catalytica is developing advanced products and manufacturing processes which
use the Company's proprietary chemical catalysis technologies by lowering
manufacturing costs and reducing hazardous byproducts. The Company has developed
significant expertise in catalysis, an essential step in the production of many
industrial products. The Company's product sales are derived from sales of
pharmaceutical products and its research and development revenues are derived
principally from the Company's pharmaceutical, Combustion Systems, and Advanced
Technology businesses.
On July 31, 1997, Catalytica Pharmaceuticals, Inc. (formerly Catalytica Fine
Chemicals, Inc.), a subsidiary of the Company, acquired from Glaxo Wellcome Inc.
a pharmaceutical manufacturing facility (the "Facility") located in Greenville,
North Carolina (the "Acquisition"), in exchange for (i) $245.1 million in cash;
(ii) 250,000 shares of Junior Preferred Stock of Catalytica Pharmaceuticals;
(iii) warrants to purchase 2,000,000 shares of the Company's Common Stock at an
exercise price of $12.00 per share and (iv) 10% of the earnings before interest
and taxes in excess of an aggregate cumulative amount of $10 million
attributable to the sterile products portion of the Facility, up to an
aggregate cumulative payment to Glaxo Wellcome of an additional $25.0 million.
At the closing of the Acquisition Catalytica recorded $117.5 million of
inventory and $146.7 million of property, plant and equipment. During the nine
months ended September 30, 1997, 82.8% of the Company's pharmaceutical product
revenues were derived from sales to Glaxo Wellcome under the Supply Agreement.
With the closing of the Acquisition, the Company closed a sale of 13,270,000
shares of its Class A Common Stock and 16,730,000 shares of its Class B Common
Stock to Morgan Stanley Capital Partners III, L.P. and two affiliated funds
("MSCP") (collectively, the "Stock Sale"), at a price of $4.00 per share, for an
aggregate of $120,000,000. As a result of the Stock Sale, as of September 30,
1997, MSCP owned approximately 40% of the Company's outstanding voting
securities and approximately 60% of the Company's outstanding securities on a
fully converted basis. See "Notes 7, 8, and 10 of Notes to Unaudited Condensed
Consolidated Financial Statements."
In addition to the equity investment by MSCP, the Company, The Chase Manhattan
Bank ("Chase") and Chase Securities Inc. ("CSI") have entered into a Credit
Agreement pursuant to which a syndicate of banks led by Chase agreed to lend
Catalytica Pharmaceuticals an aggregate of up to $200,000,000 (the "Debt
Facilities"). The Debt Facilities consist of a senior secured term loan facility
(the "Term Debt Facility") in an aggregate principal amount of $125,000,000 and
a senior secured revolving facility (the "Revolving Debt Facility") in an
aggregate principal amount of $75,000,000. Up to $20,000,000 of the Revolving
Debt Facility will be available for the issuance of letters of credit. The Term
Debt Facility will mature four and one-half years after consummation of the
Acquisition and will amortize in quarterly installments commencing on the last
day of the third fiscal quarter of 1998 in aggregate annual amounts of (i)
$50,000,000 in the year 1998, (ii) $37,500,000 in the year 1999, (iii)
$20,000,000 in the year 2000, and (iv) $17,500,000 in the year 2001. The
Revolving Debt Facility will mature four and one-half years after consummation
of the Acquisition. See Financing of the Acquisition for a discussion of the
Debt Facilities. As of September 30, 1997, $14,600,000 was outstanding under the
revolving debt facility and $125,000,000 was outstanding under the senior
secured term facility.
The Company's business has not been profitable until this quarter, and as of
September 30, 1997, the Company had an accumulated deficit of $51.6 million. To
achieve continued profitable operations, Catalytica must
9
successfully manage the operations of the new Facility, and, to a lesser extent,
successfully develop, manufacture, introduce and market or license its
combustion systems and catalytic processes. The Company's success will depend on
its ability to complete the transition from emphasizing research and development
to full commercialization and sale of its products. The Company began
manufacturing, marketing and selling pharmaceutical intermediates in 1994 and,
with the Acquisition of the Facility, has substantially increased its
manufacturing of pharmaceutical products in 1997.
The additional facilities, employees and business volumes resulting from the
Acquisition has substantially increased the expenses and working capital
requirements and placed substantial burdens on the Company's management
resources. Furthermore, the success of the Acquisition and the Company's future
results depend, in significant part, on the levels of manufacturing business
developed by Catalytica Pharmaceuticals. In the event Catalytica Pharmaceuticals
does not obtain additional new customers, which could involve additional
business from Glaxo Wellcome, on terms sufficient to offset the costs associated
with operating and maintaining the Facility, and with servicing the debt
incurred in connection with the acquisition of the Facility, the Company's
consolidated results of operations and financial condition would be materially
adversely affected.
Due to the size of the Acquisition, the results of operations of Catalytica
Pharmaceuticals have a material effect on the consolidated results of operations
of the Company, and the results of operations of the Company's other businesses
will be insignificant for the remainder of 1997 and 1998.* The anticipated
revenues from the Supply Agreement with Glaxo Wellcome are expected to allow the
Company to achieve continued profitable operations for Catalytica
Pharmaceuticals for the remainder of 1997 and for 1998.* After 1998, Catalytica
Pharmaceuticals' profitability will depend on its success and timing in
obtaining new customers, including possible new agreements with Glaxo Wellcome.*
The Company anticipates that its earnings per share will be reduced by $.07
in the fourth quarter of 1997*, as it has repurchased 5,000,000 shares of its
Class B Common Stock from MSCP at a price of $4.75 per share with the proceeds
from a warrant issuance which occurred during the third fiscal quarter of 1997.
Earnings per share for this purpose was calculated assuming an average of 52
million shares outstanding during the fourth quarter.
Manufacturing at the Facility is conducted in three district operations:
primary, secondary and sterile. There is excess manufacturing capacity that will
be available at the primary facility beginning in mid-1998 and based on
marketing efforts to date Catalytica Pharmaceuticals expects it will have one or
more customers for some or all of the unused primary facility beginning in mid-
1998.* There is substantial excess manufacturing capacity immediately available
at the secondary and sterile facilities, but because of the long lead times
required to obtain necessary regulatory approvals to manufacture secondary and
sterile products at these facilities, Catalytica Pharmaceuticals does not
anticipate additional significant revenue from such facilities until 1998 or
1999 at the earliest*. Catalytica Pharmaceuticals' inability to fill additional
available capacity or to reduce costs in conjunction with lower levels of
capacity utilization would have a material adverse effect on the Company's
results of operations.
On May 8, 1996, Catalytica Pharmaceuticals, announced that Pfizer Inc. had
signed an agreement to infuse $15 million in Catalytica Pharmaceuticals. These
funds originally provided Pfizer a 15 percent interest in Catalytica
Pharmaceuticals and a five-year research and development ("R&D") commitment by
Catalytica Pharmaceuticals to develop new processes and technology for the
manufacture of Pfizer products. Prior to this investment, Catalytica
Pharmaceuticals was a wholly-owned subsidiary of Catalytica, Inc. Pursuant to
the terms of the Acquisition, Glaxo Wellcome received approximately a 1.5%
equity interest in Catalytica Pharmaceuticals and the Company purchased
additional stock shares of Catalytica Pharmaceuticals, which resulted in
Pfizer's ownership interest decreasing to approximately 4.4%.
During the past four years, Catalytica Pharmaceuticals and Pfizer have
collaborated on the development of proprietary processes for key intermediate
products for several of Pfizer's promising new pharmaceuticals. The Pfizer drugs
are at varying stages of approval by the Food and Drug administration, ranging
from Phase II clinical trials through the New Drug Application stage. Catalytica
Pharmaceuticals currently manufactures intermediates for certain Pfizer drugs
and anticipates becoming a supplier of intermediates to Pfizer for other
pharmaceutical products in the future.* There can be no assurance, however, that
orders will be forthcoming from Pfizer.
10
On June 28, 1996, Catalytica completed the sale of substantially all the
assets of Advanced Sensor Devices, Inc. ("ASD") to Monitor Labs, Inc. Prior to
the sale, ASD produced continuous emission monitors ("CEMs") based on
proprietary catalytic sensors. The terms for selling substantially all of ASD's
assets included an initial payment of approximately $1.1 million at the closing,
a second payment of $0.5 million at year end, and a royalty stream based on
future revenues. The Company recorded a total gain of $0.9 million on the sale
of these assets.
On October 15, 1996, Catalytica's subsidiary Catalytica Combustion Systems
Inc. ("CCSI") and Woodward Governor Company formed a Delaware limited liability
company in connection with a 50/50 joint venture to serve the gas turbine
retrofit market for installed, out-of-warranty engines. The new company,
GENXON/(TM)/ Power Systems, LLC, will initially upgrade the combustion systems
of installed turbines with XONON which will reduce emissions and permit greater
asset utilization for both power generation and mechanical drive markets. These
planning services are expected to result in the delivery of an integrated
product portfolio which includes CCSI's XONON/(TM)/ technology for ultra low NOx
emissions, Woodward's NetCon(R) control systems, turbine overhaul and upgrades,
as well as contract maintenance and service.*
The initial capital commitment of the GENXON joint venture partners was $10
million--$2 million from CCSI and $8 million from Woodward--payable over time as
the funds were required by the joint venture. This initial capital commitment of
$10 million was reached during the third quarter of 1997. Continued funding of
the joint venture beyond the initial $10 million commitment has occurred on a
50/50 basis with each joint venture partner contributing $600,000 during the
third quarter, bringing the total investment in the joint venture to $11.2
million to date. Although CCSI and Woodward intend to continue the funding of
this joint venture*, neither joint venture partner is contractually required to
make further capital infusions exclusive of some required capital infusions
which are predicated upon reaching certain milestones. CCSI has contributed to
the joint venture an exclusive license for the use of its catalytic combustion
technology, and Woodward contributed to the joint venture an exclusive license
for the use of its instrumentation and control systems for gas turbine catalytic
combustors. CCSI began accounting for its share of the joint venture gain or
loss upon the first cash infusion totaling $1.0 million which occurred on
January 3, 1997 upon completion of a milestone. Prior to January 3, 1997, the
joint venture was being funded entirely by Woodward Governor. For the nine
months ended September 30, 1997, the Company has recorded losses of $2.6 million
on the joint venture.
RESULTS OF OPERATIONS
Net revenues for the three and nine months ended September 30, 1997 increased
by 1,789% and 631% respectively, compared to the same quarter in fiscal 1996 due
to an increase in product sales attributable to the Greenville facility and the
related Supply Agreement with Glaxo Wellcome. During the nine months ended
September 30, 1997, 82.8% of the Company's pharmaceutical product revenues were
derived from sales to Glaxo Wellcome under the Supply Agreement. A slight
decrease in research revenues for the third quarter of 1997 was primarily due to
a shift of certain catalytic combustion research and development activities from
Catalytica to the GENXON joint venture. An increase in research revenues for the
first nine months of 1997 reflects a funded research commitment associated with
the five-year R&D agreement between Catalytica Pharmaceuticals and Pfizer to
develop new processes and technology for the manufacture of Pfizer products (See
overview above).
Product revenues for the third quarter and year-to-date periods included $3.8
million in "guaranteed revenues" related to the Glaxo Wellcome Supply Agreement.
These "guaranteed revenues" represent "revenue shortfalls" which is the
difference between actual product shipments to Glaxo Wellcome and "guaranteed"
product shipments per the Supply Agreement. These revenue shortfall payments
help offset fixed manufacturing costs associated with manufacturing capacity
reserved for Glaxo Wellcome as required in the long term Supply Agreement. See
"Overview" above.
Cost of goods sold increased 3,472% for the third quarter of 1997 and
increased 1,031% for the first nine months of 1997. The increase in cost of
goods sold for both the three and nine month periods reflects increased physical
volume of product sales of fine chemical products primarily due to an increase
in sales attributable to the
11
Greenville facility and the related Supply Agreement with Glaxo Wellcome.
Margins on the fine chemical products are subject to fluctuations from quarter
to quarter due to various factors including the mix of products being
manufactured, manufacturing efficiencies achieved on production runs, the length
of down-time associated with setting up new productions runs, and numerous other
variables present in the chemical manufacturing environment.
Research and development expenses increased 13% for the three months ended
September 30,1997 and decreased 10.5% for the nine months ended September 30,
1997, as compared to the same periods in 1996. The three month increase is
attributable to research and development expenses associated with the Greenville
facility. The nine month decrease is largely due to a shift of certain catalytic
combustion research and development costs from Catalytica to the GENXON joint
venture (See overview above). This transfer of R&D funding began August 1, 1996,
and resulted in approximately $1.8 million of research and development costs
being financed by the joint venture rather than Catalytica during the first
three quarters of fiscal 1997. Cessation of all research activities of Advanced
Sensor Devices ("ASD") following the sale of its assets on June 28, 1996, also
contributed approximately $0.4 million towards the year to date reduction of R&D
expenses (See overview above). Research and development expenses may fluctuate
from quarter to quarter.
Selling, general and administrative expenses ("SG&A") increased 114% for the
third quarter of 1997 and increased 19% for the first nine months of 1997
compared to the same periods of 1996 largely due to SG&A costs incurred at the
Greenville facility. The Company has incurred significant legal, accounting, and
other SG&A related expenditures as a result of the acquisition of the Greenville
facility. Included in these costs is $3.2 million which have been capitalized as
part of the purchase price of the Facility.
Net interest income decreased 12% for the third quarter of 1997 and decreased
9% for the first nine months of 1997 when compared to the same periods last year
due to reduced balances of short-term investments.
Net interest expense increased 2,934% for the third quarter of 1997 and
increased 633% for the first nine months of 1997 when compared to the same
periods last year due to the initiation of The Chase Manhattan Bank "Term Debt
Facility" for $125,000,000, and $14,600,000 borrowing on the Chase Manhattan
Bank "Revolving Debt Facility" during the last two months of the third quarter
of 1997.
On January 3, 1997, Catalytica Combustion Systems, Inc. ("CCSI") made its
first cash infusion of $1.0 million into the GENXON joint venture. CCSI
recognized its 50% share of GENXON losses, of $1.15 million for the third
quarter of 1997, and $2.6 million for the first nine months of 1997 up to its
capital contribution of $2.6 million. The Company estimates it may make
additional capital contributions to the joint venture during the remaining
quarter of 1997. If GENXON continues to generate losses during this time frame,
the Company will record its share of these losses to the extent of its capital
contribution. However, these losses may be partially offset by reimbursements
for past R&D expenses if certain GENXON milestones are achieved.
LIQUIDITY AND CAPITAL RESOURCES
Total cash and cash equivalents plus short-term investments increased to $44.3
million at September 30, 1997, compared to $23.8 million at December 31, 1996.
This increase in cash is primarily due to borrowings against various credit
facilities, funds received from the sale of common stock to Morgan Stanley and
through stock option, and warrant exercises.
During the past several years, the Company has obtained various lines of
credit to fund capital purchases and future working capital needs. One of these
lines of credit collateralized with accounts receivable was increased to $3.5
million in 1996. On July 31, 1997, this line of credit was repaid with
borrowings under a credit facility with a syndicate of banks led by The Chase
Manhattan Bank entered into in connection with the Acquisition.
With the closing of the Acquisition, the Company closed a sale of 13,270,000
shares of its Class A Common Stock and 16,730,000 shares of its Class B Common
Stock to Morgan Stanley Capital Partners III, L.P. and two affiliated funds
("MSCP") (collectively, the "Stock Sale"), at a price of $4.00 per share, for an
aggregate of
12
$120,000,000. As a result of the Stock Sale and the subsequent redemption of
5,000,000 shares of Class B Common Stock, MSCP owns approximately 40% of the
Company's outstanding voting securities and approximately 47.3% of the Company's
outstanding securities on a fully converted basis.
In addition to the equity investment by MSCP, the Company, The Chase Manhattan
Bank ("Chase") and Chase Securities Inc. ("CSI") have entered into a Credit
Agreement pursuant to which a syndicate of banks led by Chase has agreed to lend
Catalytica Pharmaceuticals an aggregate of up to $200,000,000 (the "Debt
Facilities"). The Debt Facilities consist of a senior secured term loan facility
(the "Term Debt Facility") in an aggregate principal amount of $125,000,000 and
a senior secured revolving facility (the "Revolving Debt Facility") in an
aggregate principal amount of $75,000,000. Up to $20,000,000 of the Revolving
Debt Facility will be available for the issuance of letters of credit. The Term
Debt Facility will mature four and one-half years after consummation of the
Acquisition and will amortize in quarterly installments commencing on the last
day of the third fiscal quarter of 1998 in aggregate annual amounts of (i)
$50,000,000 in the year 1998, (ii) $37,500,000 in the year 1999, (iii)
$20,000,000 in the year 2000, and (iv) $17,500,000 in the year 2001. The
Revolving Debt Facility will mature four and one-half years after consummation
of the Acquisition. As of September 30, 1997, $14,600,000 was outstanding under
the revolving debt facility and $125,000,000 was outstanding under the senior
secured term facility.
The Company's operations to date have required substantial amounts of cash. As
part of the financing of the Acquisition, Catalytica Pharmaceuticals incurred
approximately $100 million of long-term indebtedness. The Company and its
subsidiaries have guaranteed this indebtedness. As a result of this increased
leverage, Catalytica Pharmaceuticals' principal and interest obligations has
increased substantially. The Company anticipates that cash flows associated with
the Supply Agreement will be sufficient to reduce indebtedness incurred in
connection with the Acquisition to a level supportable by the current assets of
the Company.* The degree to which Catalytica Pharmaceuticals is leveraged could
adversely affect Catalytica Pharmaceuticals' and the Company's ability to obtain
additional financing for working capital, acquisitions or other purposes and
could make Catalytica Pharmaceuticals and the Company more vulnerable to
economic downturns and competitive pressures. The Company's future capital
requirements will depend on many factors, including Catalytica Pharmaceuticals
level of business beyond the Supply Agreement with Glaxo Wellcome, the rate of
commercialization of the Company's catalytic combustion systems, and the need to
expand manufacturing capacity for pharmaceutical or combustion systems business.
Adequate funds for future operations, whether from the financial markets or from
collaborative or other arrangements, may not be available when needed or on
terms acceptable to the Company and, if available or acceptable to the Company,
may result in significant dilution to existing stockholders.
The Company distributed, at no cost, to each holder of Common Stock of record
as of August 22, 1997 (the "Record Date"), one Warrant for each three shares of
Common Stock held on the Record Date. The total number of warrants issued was
6,947,245. No Warrants to purchase fractional shares were issued, and,
accordingly, the number of Warrants issued to each stockholder was rounded down
to the nearest whole Warrant. Each Warrant entitles the holder to purchase one
share of Common Stock at the exercise price of $4.00 (the "Warrant Price"). The
Warrants expired at 5:00 p.m. (Pacific time) on October 31, 1997 (the "Warrant
Expiration Date"). Warrant holders elected to (i) purchase Common Stock through
the exercise of their Warrants, (ii) trade their Warrants or (iii) allow their
Warrants to expire unexercised.
The Company used the net proceeds from the exercise of the Warrants to
repurchase an aggregate of 5,000,000 shares of its Class B Common Stock issued
to MSCP on July 31, 1997. The repurchase price was $4.75 per share, as such
repurchase was consummated prior to November 30, 1997. The Class A Common Stock
and Class B Common Stock could not be repurchased after May 31, 1998. Remaining
proceeds, of the Warrant Issuance will be used for general corporate purposes.
As of October 31, 1997, 6,922,996 shares have been acquired through the
exercise of the Warrants, which generated gross proceeds of $27,691,984. The
Company has used $23,750,000, to repurchase 5,000,000 shares of the MSCP Class B
Common Stock. The repurchase will be reflected in the Company's financial
statements in the period ending December 31, 1997. The Company's earnings
per share will be reduced by $.07 due to this repurchase. Earnings per share
for this purpose was calculated assuming an average of 52 million shares
outstanding during the fourth quarter.
13
RISK FACTORS
This report contains forward-looking statements within the meaning of Section
27A of the Securities Act and Section 21E of the Exchange Act, including those
statements which have been identified by an asterisk ("*") and other statements
regarding the Company's strategy, financial performance and revenue sources.
Actual results could differ materially from those projected in the forward-
looking statements as a result of the risk factors set forth below and elsewhere
in this report. In addition to the other information in this report, the
following factors should be carefully considered in evaluating the Company and
its business.
History of Operating Losses and Uncertainty of Future Results. The Company's
business has not been profitable until this quarter, and as of September 30,
1997, the Company had an accumulated deficit of $51.6 million. To achieve
continued profitable operations, Catalytica must successfully manage the
operations of the Facility, and, to a lesser extent, successfully develop,
manufacture, introduce and market or license its combustion systems and
catalytic processes. The Company's success will depend on its ability to
complete the transition from emphasizing research and development to full
commercialization and sale of its products. The Company began manufacturing,
marketing and selling pharmaceutical intermediates in 1994 and, with the
Acquisition of the Facility, will substantially increase its manufacturing of
pharmaceutical products in 1997.
The additional facilities, employees and business volumes resulting from the
Acquisition substantially increased the expenses and working capital
requirements and placed substantial burdens on the Company's management
resources. Furthermore, the success of the Acquisition and the Company's future
results depend, in significant part, on the levels of manufacturing business
developed by Catalytica Pharmaceuticals. In the event Catalytica Pharmaceuticals
does not obtain additional new customers, which could involve additional
business from Glaxo Wellcome, on terms sufficient to offset the costs associated
with operating and maintaining the Facility, and with servicing the debt
incurred in connection with the acquisition of the Facility, the Company's
consolidated results of operations and financial condition would be materially
adversely affected.
Due to the size of the Acquisition, the results of operations of Catalytica
Pharmaceuticals have a material effect on the consolidated results of operations
of the Company, and the results of operations of the Company's other businesses
will be insignificant for the remainder of 1997 and 1998.* The anticipated
revenues from the Supply Agreement with Glaxo Wellcome are expected to allow the
Company to achieve profitable operations for Catalytica Pharmaceuticals for the
remainder of 1997 and for 1998.* After 1998, Catalytica Pharmaceuticals'
profitability will depend on its success and timing in obtaining new customers,
including possible new agreements with Glaxo Wellcome.* The Company anticipates
that its earnings per share will be reduced by $.07 in the fourth quarter
of 1997*, as it has repurchased 5,000,000 shares of its Class B Common Stock
from MSCP at a price of $4.75 per share, for an aggregate of $23,750,000 with
the proceeds from a warrant issuance which occurred during the third fiscal
quarter of 1997. Earnings per share for this purpose was calculated assuming
an average of 52 million shares outstanding during the fourth quarter.
Manufacturing at the Facility is conducted in three district operations:
primary, secondary and sterile. There is excess manufacturing capacity
available at the primary facility beginning in mid-1998 and based on marketing
efforts to date Catalytica Pharmaceuticals expects it will have one or more
customers for some or all of the unused primary facility beginning in mid-
1998.* There is substantial excess manufacturing capacity immediately
available at the secondary and sterile facilities, but because of the long
lead times required to obtain necessary regulatory approvals to manufacture
secondary and sterile products at these facilities, Catalytica Pharmaceuticals
does not anticipate additional significant revenue from such facilities until
1998 or 1999 at the earliest*. Catalytica Pharmaceuticals' inability to fill
additional available capacity or to reduce costs in conjunction with lower
levels of capacity utilization would have a material adverse effect on the
Company's results of operations. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
Management of Growth; Limitation of Existing Information Systems. The
Company's business is currently experiencing a period of growth that has placed
and is expected to continue to place a significant strain on the Company's
personnel and resources. The Company's ability to manage future growth, if any,
will depend on its ability to continue to implement and improve operational,
financial and management information and control systems on a timely basis,
together with maintaining effective cost controls. In particular the Company's
existing information system is not year 2000 compliant and as a result, the
Company is modifying the system. To support any future growth, the Company
will
14
need to hire more sales, marketing, support and administrative personnel, and
expand customer service capabilities. Competition worldwide for the necessary
personnel in the Company's industry is intense. There can be no assurance that
the Company will be able to attract and retain the necessary personnel or that
it will be able to satisfy customer demand in a timely fashion and
satisfactorily support its customers and operations.
Reliance on Relationship with Glaxo Wellcome. Catalytica Pharmaceuticals
estimates that aggregate payments by Glaxo Wellcome under the Supply Agreement
will total approximately $800 million, which include guaranteed revenues plus
the cost of raw materials.* The annual level of guaranteed revenues declines
significantly after 1998, but is expected to continue to represent a significant
source of revenue for Catalytica Pharmaceuticals.* Catalytica Pharmaceuticals is
substantially dependent on Glaxo Wellcome for the next two and one half years
and will continue to be dependent on Glaxo Wellcome in part thereafter until the
end of the term of the Supply Agreement. Catalytica Pharmaceuticals' business
and the Company's consolidated results of operations would be adversely affected
if Catalytica Pharmaceuticals does not successfully perform its obligations
under the Supply Agreement. This could result in increased costs to the Company
or in possible termination of the Supply Agreement by Glaxo Wellcome.
New Operating Strategy and Need to Hire Additional Personnel. The Facility has
been operated primarily as a captive manufacturing facility by Glaxo Wellcome
with only a limited portion of the Facility devoted to third party
manufacturing. Accordingly, the employees currently operating the Facility and
the managers hired to manage the operations of the Facility have limited prior
experience in conducting operations as a third party manufacturer. There is
limited infrastructure and an insufficient number of personnel at the Facility
currently involved in sales and marketing, research and development, payroll,
purchasing, accounting and information systems functions. The Company will need
to establish and maintain the appropriate infrastructure and hire and train
qualified personnel to perform these functions at the Facility. There can be no
assurance that the Company will successfully establish the infrastructure or be
able to hire qualified personnel in a timely fashion. There can be no assurance
that Catalytica Pharmaceuticals will be able to establish a successful sales and
marketing capability. Any failure to successfully establish these capabilities
at the Facility on a timely basis would have a material adverse effect on the
Company's consolidated results of operations.
Dependence on Key Personnel. The Company's success is dependent on the
retention of principal members of its management and scientific staff and on the
ability to continue to attract, motivate and retain additional key personnel.
Competition for such key personnel is intense, and the loss of the services of
key personnel or the failure to recruit necessary additional personnel could
have a material adverse effect on the Company's operations and on its research
and development efforts. The Company does not have non-competition agreements
with any of its key employees. The Company's anticipated expansion into areas
and activities requiring additional expertise, such as manufacturing, marketing
and distribution, are expected to place increased demands on the Company's
resources. These activities are expected to require the addition of new
personnel with expertise in these areas and the development of additional
expertise by existing personnel. The successful integration of the Facility with
the operations of Catalytica Pharmaceuticals will be significantly dependent
upon Catalytica Pharmaceuticals' ability to attract and retain the personnel
(including former Glaxo Wellcome employees) necessary to effectively integrate,
and thereafter operate, the combined businesses. In this regard, Catalytica
Pharmaceuticals has hired certain key managers of the Facility. Any failure on
the part of Catalytica Pharmaceuticals to attract or retain necessary personnel
would have a material adverse effect on the Company's consolidated results of
operations.
Uncertainties Related to Combustion Systems Business. The Company, through its
subsidiary Catalytica Combustion Systems, Inc. ("CCSI"), and the GENXON joint
venture, is still conducting research and development on its combustion systems.
Prior to commercialization of its combustion systems, the Company's products
will be required to undergo rigorous testing by turbine manufacturers. Ultimate
sales of the Company's combustion system products will depend upon the
acceptance and use of the Company's technology by a limited number of turbine
manufacturers and the Company's ability to enter into commercial relationships
with these manufacturers. The Company's subsidiary, CCSI, is currently working
with leading turbine manufacturers, including: General Electric in large
turbines, Allison Engine Co., a subsidiary of Rolls Royce, and Solar, a
subsidiary of Caterpillar, Inc., in medium size turbines. In addition, through
its joint venture company GENXON, CCSI is developing complete combustor systems
for Affiliated Group of Companies (AGC), to be used on small Kawasaki Heavy
Industries
15
turbines for mobile cogeneration applications. GENXON is also developing
complete combustor systems utilizing Catalytica's combustion technology for end
users to be retro fitted on older out-of-warranty turbines no longer supported
by OEM's. Neither the Company, its subsidiary CCSI, nor the joint venture
company GENXON have formal long-term agreements in place with many of these
companies. The Company's ability to complete research and development and
introduce commercial systems for these markets would be adversely affected if
any of these companies terminated its relationship with the Company or GENXON.
If such terminations occurred, there is no assurance as to whether the Company
could enter into a similar relationship with another manufacturer.
The Company currently has limited manufacturing and marketing capability for
its combustion products, and to the extent that the Company's existing
facilities are inadequate , the Company will be required to develop or acquire
manufacturing capability. In order to market any of its combustion system
products, the Company will be required to develop marketing capability, either
on its own or in conjunction with others. There can be no assurance that the
Company will be able to manufacture its products successfully or develop an
effective marketing and sales organization. In addition, some of the Company's
combustion systems and processes are expected to be sold as components of large
systems such as natural gas turbines for electric power plants. Accordingly, the
rate of adoption of the Company's systems and processes may depend in part on
economic conditions which affect capital investment decisions, as well as the
regulatory environment. There can be no assurance that the Company's combustion
products will be economically attractive when compared to competitive products.
In October 1996 Combustion Systems and Woodward Governor Company formed a
Delaware limited liability company in connection with a 50/50 joint venture to
serve the gas turbine retrofit market for installed, out-of-warranty engines.
The new company, GENXON/(TM)/ Power Systems, LLC ("GENXON"), will initially
upgrade the combustion systems of installed turbines with XONON which will
reduce emissions and permit greater asset utilization for both power generation
and mechanical drive markets. GENXON plans to deliver an integrated product
portfolio which includes Combustion Systems' system for ultra low NOx emissions,
Woodward's control systems, turbine overhaul and upgrades, as well as contract
maintenance and service*. Unlike Catalytica Combustion Systems' efforts to date
which have focused only on the design of the catalyst assembly, GENXON is
developing entire combustion systems. The development of complete combustion
systems by GENXON to serve the retrofit market will require the design of new
combustion chambers to be retrofitted on existing turbines. This new combustion
chamber will incorporate a XONON catalyst. There can be no assurance that GENXON
will be successful in developing new combustion chambers that will work in lieu
of the current design that does not incorporate a catalyst. There can be no
assurance that GENXON's products will be economically attractive when compared
to competitive products.
The initial capital commitment of the GENXON joint venture partners was $10
million--$2 million from CCSI and $8 million from Woodward--payable over time as
the funds were required by the joint venture. This initial capital commitment of
$10 million was reached during the third quarter of 1997. Continued funding of
the joint venture beyond the initial $10 million commitment has occurred on a
50/50 basis with each joint venture partner contributing $600,000 during the
third quarter, bringing the total investment in the joint venture to $11.2
million to date. Although CCSI and Woodward intend to continue the funding of
this joint venture, neither joint venture partner is contractually required to
make further capital infusions exclusive of some required capital infusions
which are predicated upon reaching certain milestones. If the milestones are
not met, and the Company desired to complete any projects being developed by the
joint venture, the Company could be required to fund the projects itself if
Woodward decides not to make any additional capital contributions to GENXON. If
such an event were to occur, it could have a material adverse effect on the
Company's results of operations and financial condition.
On January 3, 1997, Catalytica Combustion Systems, Inc. (CCSI) made its first
cash infusion of $1.0 million into the GENXON joint venture. CCSI recognized its
50% share of GENXON losses of $1.15 million for the third quarter of 1997 and
$2.6 million for the first nine months of 1997 up to its capital contribution of
$2.6 million. Accordingly, a $2.6 million loss on the joint venture was
recognized in the results of operations. The Company estimates it may make
additional capital contributions to the joint venture during the remaining
quarter of 1997. If GENXON continues to generate losses during this time frame,
the Company will record its share of these losses to the extent of its capital
contribution. However, these losses may be partially offset by reimbursements
for past R&D
16
expenses if certain GENXON milestones are achieved. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
Future Capital Requirements and Uncertainty of Additional Funding; Increased
Leverage. The Company's operations to date have required substantial amounts of
cash. As part of the financing of the Acquisition, Catalytica Pharmaceuticals
incurred approximately $100 million of long-term indebtedness. The Company and
its subsidiaries have guaranteed this indebtedness. As a result of this
increased leverage, Catalytica Pharmaceuticals' principal and interest
obligations will be increased substantially. The Company anticipates that cash
flows associated with the Supply Agreement will be sufficient to reduce
indebtedness incurred in connection with the Acquisition to a level supportable
by the current assets of the Company.* The degree to which Catalytica
Pharmaceuticals is leveraged could adversely affect Catalytica Pharmaceuticals'
and the Company's ability to obtain additional financing for working capital,
acquisitions or other purposes and could make Catalytica Pharmaceuticals and the
Company more vulnerable to economic downturns and competitive pressures. The
Company's future capital requirements will depend on many factors, including
Catalytica Pharmaceuticals level of business beyond the Supply Agreement with
Glaxo Wellcome, the rate of commercialization of the Company's catalytic
combustion systems, and the need to expand manufacturing capacity for
pharmaceutical or combustion systems business. Adequate funds for future
operations, whether from the financial markets or from collaborative or other
arrangements, may not be available when needed or on terms acceptable to the
Company and, if available or acceptable to the Company, may result in
significant dilution to existing stockholders. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
Risk of Product Liability. Although Catalytica Pharmaceuticals intends to seek
indemnification from its customers for any product liability claims that may
result from the pharmaceutical products it produces, there can be no assurance
that Catalytica Pharmaceuticals will not ultimately be found liable for any
product liability claims regarding products it manufactures. Catalytica
Pharmaceuticals expects it will be required to indemnify its customers for
product liability claims if a manufacturing defect results in injury. There can
be no assurance that Catalytica Pharmaceuticals will be able to obtain or
maintain product liability insurance in the future on acceptable terms or with
adequate coverage against potential liabilities. If Catalytica Pharmaceuticals
is found liable in a product liability claim and the Company does not have
adequate product liability insurance or indemnification, the Company's
consolidated results of operations could be materially adversely effected.
Additionally, under the Supply Agreement, Catalytica Pharmaceuticals is
obligated to maintain $100,000,000 of product liability insurance. If Catalytica
Pharmaceuticals does not meet this requirement, it would be considered a default
under the Supply Agreement.
Hazardous Materials and Environmental Matters. The Company's research and
development activities and fine chemicals manufacturing involve the use of many
hazardous chemicals. The use of such chemicals will significantly increase as a
result of the acquisition of the Facility from Glaxo Wellcome. The Company is
subject to extensive federal, state and local laws and regulations governing the
use, manufacture, storage, handling and disposal of such materials and
associated waste products. The Company believes that its properties and
operations comply in all material respects with applicable environmental laws;
however, the risk of environmental liabilities cannot be completely eliminated.
Public awareness of environmental issues has increased the impact of such laws
on the conduct of manufacturing operations and ownership of property. Any
failure by the Company to comply with present or future environmental laws could
result in cessation of portions or all of the Company's operations, impositions
of fines, restrictions on the Company's ability to carry on or expand its
operations, significant expenditures by the Company to comply with environmental
laws and regulations, and/or liabilities in excess of the resources of the
Company. The Company has environmental impairment insurance with regard to first
party and third party liability in the amount of $25,000,000 (with a $1,000,000
retention) with respect to the Facility only. There can be no assurance that the
Company will not be required to make renovations or improvements to comply with
environmental laws and regulations in the future. The Company's operations,
business or assets could be materially adversely affected in the event such
environmental laws or regulations require the Company to modify current
facilities substantially or otherwise limit the Company's ability to conduct or
expand its operations.
Catalytica Pharmaceuticals expects that significant expenditures may be
incurred at the Facility as a result of new environmental regulations currently
under consideration. The United States Environmental Protection Agency
17
(the "EPA") is considering new regulations for the pharmaceutical industry under
the authority of the federal Clean Air Act. These proposed regulations would
require the installation of "Maximum Achievable Control Technology" for certain
hazardous air pollutant emissions sources ("Pharmaceutical MACT"). The EPA is
also considering changes to its particulate matter emissions regulations as well
as regulation of certain ozone precursor emissions. As these rules are in the
early stages of consideration by the EPA, and as there can be no assurance of
their adoption, the additional cost of complying with such regulations cannot be
determined at this time. There can be no assurance that Catalytica
Pharmaceuticals will not be required to make additional renovations or
improvements to comply with environmental laws and regulations in the future.
Catalytica Pharmaceuticals' operations, business and assets could be materially
adversely affected in the event such environmental laws or regulations require
Catalytica Pharmaceuticals to modify the current Facility substantially or
otherwise limit Catalytica Pharmaceuticals' ability to conduct or expand its
operations.
Current and Potential Environmental Contamination at Catalytica
Pharmaceuticals' Two Sites. The Company through a subsidiary leases the land on
which its Bayview facility in East Palo Alto, California is located from Rhone
Poulenc, Inc., ("Rhone Poulenc"). The past activities of Rhone Poulenc's
predecessor caused significant soil and groundwater contamination of the
facility and a down gradient area located along the San Francisco Bay.
Consequently, the site is subject to a clean up and abatement order issued by
the Bay Area Regional Water Quality Control Board ("RWQCB") which currently
requires stabilization, containment and monitoring of the arsenic and volatile
organic contamination at the site and surrounding areas. The ground lease
between Rhone Poulenc and the Company includes an indemnity by Rhone Poulenc
against any costs and liabilities that the Company might incur to fulfill the
RWQCB order and to otherwise address the contamination that is the subject of
the order. The Company also has obtained an indemnification from Novartis (the
immediately preceding owner/operator of the facility) against any costs and
liability the Company may incur with respect to any contamination caused by
Novartis' operations. However, there can be no assurance that the Company will
not be held responsible with respect to the existing contamination or named in
an action brought by a governmental agency or a third party because of such
contamination. If the Company is held responsible and it has contributed to the
contamination, it will be liable for any damage to third parties, and will be
required to indemnify Rhone Poulenc and Novartis for any additional clean up
costs or liability they may incur, with respect to the contamination caused by
the Company. The determination of the existence and additional cost of any such
incremental contamination contribution by the Company could involve costly and
time-consuming negotiations and litigation. Further, any such incremental
contamination by the Company or the unenforceability of either of the indemnity
agreements described above could materially adversely affect the Company's
business and results of operations.
Glaxo Wellcome has been working with the EPA and the North Carolina Department
of Environment, Health and Natural Resources (the "NCDEHNR") to investigate,
identify and remediate contamination in the soil and groundwater at the
Facility. This investigation, carried out pursuant to the federal Resource
Conservation and Recovery Act, has identified 16 different areas of the Facility
where contamination has or may have occurred. Of these 16 areas, at least five
have been identified as requiring further investigation and remediation by
NCDEHNR ("Site Contamination"). Contaminants found in the soil and groundwater
at the Facility include solvents, petroleum hydrocarbons and pesticides. As the
new owner of the Facility, Catalytica Pharmaceuticals will become liable for
such contamination. Although it is unknown at this time what further remediation
will be required at the Facility and the cost of such remediation, Glaxo
Wellcome has agreed to be primarily liable for any contamination at the Facility
site prior to the closing of the Acquisition and to perform, at its cost, the
remediation required by law for contamination of the soil and groundwater
existing at the Facility as of the Closing. The Environmental Agreement with
Glaxo Wellcome also requires Catalytica Pharmaceuticals to provide access to the
Facility and certain facility services as required for the remediation, subject
to reimbursement by Glaxo Wellcome. However, there can be no assurance that the
Company or Catalytica Pharmaceuticals will not incur unreimbursed costs or
suffer an interference with ongoing operations as a result of Glaxo Wellcome's
remediation activities or the existence of contamination at the Facility. In
addition, the Company's future development of the Facility may be limited by the
existence of contamination or Glaxo Wellcome's remediation activities. There
also can be no assurance that Catalytica Pharmaceuticals' ongoing operations at
the Facility will not cause additional contamination. The determination of the
existence and cost of any such additional contamination contributed by
Catalytica Pharmaceuticals of the Company could involve costly and time-
consuming negotiations and litigation. Furthermore, any such contamination
caused by Catalytica Pharmaceuticals or the Company could materially adversely
affect the
18
business, results of operations and financial condition of Catalytica
Pharmaceuticals and the consolidated results of operations and financial
condition of the Company.
In addition, a significant amount of asbestos containing material ("ACM") is
present at the Facility. Catalytica Pharmaceuticals believes that the ACM, in
its present condition, does not require abatement. Abatement will only be
required if and as renovations are performed in those areas containing ACM.
Catalytica Pharmaceuticals cannot presently predict whether, when or to what
extent it may need or desire to renovate areas of the Facility containing ACM.
However, should such renovations be necessary, the additional costs could be
substantial. The cash consideration for the Facility was reduced by
approximately $6,400,000, in exchange for the assumption by the Company and
Catalytica Pharmaceuticals of the liability associated with the abatement of ACM
present at the Facility. There is no assurance that such amount will be adequate
to cover the costs associated with any future abatement of ACM at the Facility.
See also "Hazardous Materials and Environmental Matters."
Catalytica Pharmaceuticals' Compliance with FDA Regulations. Many of the fine
chemicals products Catalytica Pharmaceuticals manufactures, or will manufacture
in the future, and the final drug products in which they are used are subject to
regulation for safety and efficacy by the FDA and foreign regulatory authorities
before such products can be commercially marketed. The process of obtaining
regulatory clearances for marketing is uncertain, costly and time consuming.
Catalytica Pharmaceuticals cannot predict how long the necessary regulatory
approvals will take or if its customers will ever obtain such approval for their
products. To the extent Catalytica Pharmaceuticals' customers do not obtain the
necessary regulatory approvals for marketing new products, Catalytica
Pharmaceuticals' fine chemicals product sales will be adversely affected.
Products manufactured by Catalytica Pharmaceuticals at the facility require
Catalytica Pharmaceuticals to comply with the FDA's current Good Manufacturing
Practices ("cGMP") regulations, and certain of Catalytica Pharmaceuticals'
customers, including Glaxo Wellcome, also require Catalytica Pharmaceuticals to
adhere to cGMP regulations, even if not required by the FDA. In complying with
cGMP regulations, manufacturers must continue to expend time, money and effort
in production, recordkeeping and quality control to ensure that the product
meets applicable specifications and other requirements. The FDA periodically
inspects drug manufacturing facilities to ensure compliance with applicable cGMP
requirements. Failure to comply subjects the manufacturer to possible FDA
action, such as suspension of manufacturing. The FDA also may require the
submission of any lot of the product for inspection and may restrict the release
of any lot that does not comply with FDA regulations, or may otherwise order the
suspension of manufacture, recall or seizure. Failure of Catalytica
Pharmaceuticals' customers to obtain and to maintain FDA clearance for marketing
of the products manufactured by Catalytica Pharmaceuticals, or failure of
Catalytica Pharmaceuticals to comply with cGMP regulations as required by the
FDA or Catalytica Pharmaceuticals' customers, would have a material adverse
effect on the Company's results of operations.
Influence of Environmental Regulations on Rate of Commercialization. The rate
at which the Company's catalytic combustion systems are adopted by industrial
companies will be heavily influenced by the enactment and enforcement of
environmental regulations at the federal, state and local levels. Current
federal law governing air pollution generally does not mandate the specific
means for controlling emissions, but instead, creates ambient air quality
standards for individual geographic regions to attain through individualized
planning on a regional basis in light of the general level of air pollution in
the region. Federal law requires state and local authorities to determine
specific strategies for reducing emissions or specific pollutants. Among other
strategies, state and local authorities in all areas which do not meet ambient
air quality standards must adopt performance standards for all major new and
modified sources of air pollution. The more polluted the air in a particular
region has become, the more stringent such controls must be. The Company's
revenues will depend, in part, on the standards, permit requirements and
programs these state and local authorities promulgate for reducing emissions
(including emissions of NOx) addressed by the Company's combustion and
monitoring products systems. Demand for the Company's systems and processes will
be affected by how quickly the standards are implemented and the level of
reductions required. Certain industries or companies may successfully delay the
implementation of existing or new regulations or purchase or acquire emissions
credits from other sources, which could delay or eliminate their need to
purchase the Company's systems and processes. Moreover, new environmental
regulations may impose different requirements which may not be met by the
systems and processes being developed by Catalytica or which may require costly
modifications of the Company's products. The United States Congress is currently
reviewing existing
19
environmental regulations. There can be no certainty as to whether Congress will
amend or modify existing regulations in a manner that could have an adverse
effect on demand for the Company's combustion system products.
Competition and Technological Change. There are numerous competitors in a
variety of industries in the United States, Europe and Japan which have
commercialized and are working on technologies that could be competitive with
those under development by the Company, including both catalytic and other
technological approaches. Some of these competitive products are in more
advanced stages of development and testing. The Company's competitors may
develop technologies and systems and processes that are more effective than
those being developed by the Company or that would render the Company's
technology and systems and processes less competitive or obsolete. In the fine
chemicals market, the Company faces its primary competition from pharmaceutical
companies that produce their own fine chemicals and from other fine chemicals
manufacturers such as Lonza AG and DSM Fine Chemicals. In the combustion systems
market, the Company faces its primary competition from large gas turbine power
generation manufacturers, such as General Electric Co. ("General Electric"),
Allison Engine Company ("Allison") and Solar Turbines Incorporated ("Solar"),
each of which is developing competing DLN systems for their own turbines. Many
of the Company's competitors in the combustion systems market are also potential
customers of the Company, and the Company expects to rely on these potential
customers to help commercialize its products. Most of these competitors have
greater research and development capabilities, financial resources, managerial
resources, marketing experience and manufacturing experience than the Company.
If these companies are successful in developing such products, the Company's
ability to sell its systems and processes would be materially adversely
affected. Further, since many of the Company's competitors are existing or
potential customers, the Company's ability to gain market share may be limited.
Patents and Intellectual Property. The Company has an active program of
pursuing patents for its inventions in the United States and in markets
throughout the world relevant to its business areas. The Company has 38 United
States patents and 13 pending United States patent applications, plus 70 foreign
patents and patent applications.
The Company's success will depend on the ability to continue to obtain
patents, protect trade secrets and operate without infringing on the proprietary
rights of others in the United States and other countries. There can be no
assurance that the Company's patent applications will result in the issuance of
any patent, that any of the Company's existing patents or any patents that may
be issued in the future will provide significant proprietary protection, that
any such patents will be sufficiently broad to protect the Company's technology,
or that any such patents will not be challenged, circumvented or invalidated.
There can also be no assurance that the patents of others will not have an
adverse effect on the Company. Others may independently develop similar systems
or processes or design around patents issued to the Company. In addition, the
Company may be required to obtain licenses to patents or other proprietary
rights. The Company cannot assure that any licenses required under any such
patents or proprietary rights would be made available on terms acceptable to the
Company, if at all. If Catalytica requires and does not obtain such licenses, it
could encounter delays in system or process introductions while it attempts to
design around such patents, or it could find that the development, manufacture,
sale or licensing of systems or processes requiring such licenses could be
foreclosed. The Company could incur substantial costs in defending itself or its
licensees in litigation brought by others or prosecuting infringement claims
against third parties. The Company could incur substantial costs in interference
proceedings declared by the United States Patent and Trademark Office in
connection with one or more of the Company's or third parties' patents or patent
applications, and those proceedings could also result in an adverse decision as
to the priority of the Company's inventions. The Company also protects its
proprietary technology and processes in part by confidentiality agreements with
its collaborative partners, employees and consultants. There can be no assurance
that these agreements will not be breached, that the Company will have adequate
remedies for any breach, or that the Company's trade secrets will not otherwise
become known or be independently discovered by competitors.
Concentration of Ownership. Morgan Stanley Capital Partners III, L.P. and two
affiliated funds (collectively, "MSCP") beneficially own approximately 40% of
the voting control of the Company and 47.3% of the outstanding capital stock of
the Company as of November 7,1997. As a result, MSCP is able to exercise
significant influence over all matters requiring stockholder approval, including
the election of directors and approval of all significant corporate transactions
such as any merger, consolidation or sale of all or substantially all of the
Company's assets.
20
Moreover, the Company has granted to MSCP certain contractual
rights, including representation on the Company's Board of Directors and
committees of the Board of Directors, that will give MSCP additional rights to
participate in certain actions to be taken by the Company. Such concentration of
ownership and contractual rights may have the effect of delaying, deferring or
preventing a change of control of the Company. The sale by MSCP of shares of the
Company's capital stock could constitute a change of control under the Company's
credit agreement which would trigger a default of the agreement. MSCP has agreed
not to trigger a change of control under the credit agreement. In addition, such
concentration of ownership and contractual rights could allow MSCP to prevent
significant corporate transactions. In addition, Glaxo Wellcome owns
approximately 1.5% of the outstanding capital stock of Catalytica
Pharmaceuticals and owns a warrant to purchase 2,000,000 shares of Common Stock
which represents approximately 3.8% of the Company's outstanding capital stock.
21
PART II - OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds
As of October 31, 1997, 6,922,996 shares of the Company's Common Stock were
issued in connection with the exercise of Warrants distributed as a dividend to
the Company's Common Stock holders of record on August 22, 1997. The Warrant
exercises generated gross proceeds of $27,691,984 to the Company. The remaining
24,249 Warrants expired by their terms on October 31, 1997 at 5:00 p.m. (Pacific
time).
As of November 1, 1997, the Company used $23,750,000 of the gross proceeds
generated from the exercise of the Warrants to redeem 5,000,000 shares of Class
B Common Stock from MSCP at a price of $4.75 per share. The repurchase price
was $4.75 per share, as such repurchase was consummated prior to November 30,
1997. The Class A Common Stock and the Class B Common Stock could not be
repurchased after May 30, 1998. The remaining proceeds of the Warrant exercises
will be used for general corporate purposes.
The repurchase will be reflected in the Company's financial statements in
the period ending December 31, 1997. The Company's earnings per share will
be reduced by $.07 due to this repurchase. Earnings per share for this purpose
was calculated assuming an average of 52 million shares outstanding during the
fourth quarter.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
11.1 Statement of Computation of Per Share Earnings
27 Financial Data Schedule
(b) Reports on Form 8-K
The Company filed no reports on Form 8-K during the quarter ended September
30, 1997.
All information required by other items in Part II is omitted because the
items are inapplicable, the answer is negative or substantially the same
information has been previously reported by the registrant.
22
CATALYTICA, INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: November 14, 1997
CATALYTICA, INC.
(Registrant)
/s/ Lawrence W. Briscoe
By:-------------------------------------
Lawrence W. Briscoe
Vice President and Chief
Financial Officer
Signing on behalf of the
registrant and as principal
financial officer
23